Compound Interest

Compound interest summary: 

• Compound interest is interest that is calculated more than once.

• Interest for most installment loans is compounded monthly, while credit card interest is generally compounded daily.

• The more frequently interest is compounded, the more often interest is added to the principal, and the faster the debt grows.

Compound interest definition and meaning

Compound interest means interest that is calculated and charged multiple times during the term of a loan. 

For a loan that's compounded monthly, the lender divides the annual rate by 12 and multiplies that by your loan balance every month. 

For a loan that's compounded daily, the lender divides the rate by 360 or 365 and applies it to the balance every day. 

Key concept: Compound interest is a way of calculating interest on a loan or investment multiple times during its term.

More about compound interest

Compound interest is one way for lenders to calculate the interest you owe on your loan. For example, if your loan is compounded monthly (12 times per year), the lender would divide your annual interest rate by 12 and then multiply it by your loan balance to determine your interest charge. 

Suppose you borrow $1,000 at 12% for a year and after a year you pay it back in a single payment for $1,120. That's called simple interest, and the calculation is, well, simple: 

Multiply the interest rate by the loan principal to get the amount of simple interest. Then, add that interest amount to the loan principal to get the total amount you’ll pay:

Step 1: .12 x 1,000 = 120

Step 2: 120 + 1,000 = 1,120

Now, suppose your loan compounds monthly. In that case, the lender divides your 12% rate by 12 months and charges you 1% interest per month. 

At the end of the first month, you'll be charged 1% interest on your $1,000 balance, or $10. That $10 gets added to your balance. 

The next month, you'll pay 1% again, but this time it's applied to your new balance, which is $1,010. Your interest for that month will be $10.10. At the end of a year, you’ll owe $1,126.83. 

If two loans have the same interest rate, the one that compounds more often will cost more.

Compound interest: a comprehensive breakdown

Compound interest can be a good thing when you're investing money. Your savings increases faster when you earn interest on your interest. But when you owe money, it's not so great. And since loans tend to have higher rates than savings accounts, you'll want to avoid ending up on the wrong side of that equation if you can.

One way to reduce the negative effects of compounding is to pay the interest charges even if you don’t have to. In the example above, we didn’t make any payments until the end of the year. But you could pay off the interest each month to keep your balance from growing. 

Another way to minimize loan costs is to pay extra. Usually, when you pay more than what’s required, the extra payment goes to your loan principal. If your loan balance is lower, you’ll be charged less interest the following month. Before you make extra payments, call your lender and ask if you need to do anything special. You might need to specify that you want the extra money applied to the loan principal. It’s not always automatic.

The bigger the payment you make, the less interest you pay. When you pay more than the minimum, you turn the tables on compound interest and take control of your debt.